Supreme Court Sets Defalcation Bar at Gross Recklessness under Section 523(a)(4)

In the only bankruptcy case pending before it this term, a unanimous Supreme Court has ruled that the archaic term "defalcation" used in 11 U.S.C. Sec. 523(a)(4) requires 

knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior

complained of.    Bullock v. BankChampaign, No. 11-1518 (5/13/13), Slip Op., p.1, which can be found here.  While the case represents a setback for the creditor in the specific case, the judicial hairsplitting engaged in by the Court ensures that trial courts will continue to struggle with the meaning of "defalcation."

What Happened

In 1978, a father established a trust for the benefit of his five children and named his son Randy as trustee.    The trust allowed the trustee to borrow money against the asset of the trust, which was an insurance policy.    On three occasions, Randy borrowed against the policy to make loans to himself and his mother.   The first loan was made at the father's request.   All of the loans were repaid with interest.

Was the family pleased with Randy's investing?   No.   They sued him to recover his profits made on the investments.   Although they alleged that their brother "does not appear to have had a malicious motive in borrowing funds from the trust" he "was clearly involved in self-dealing."    The state court agreed and ordered Randy to repay the trust for "the benefits he received from his breaches" (along with costs and attorney's fees).     

When Randy could not pay, he filed bankruptcy.   The replacement trustee for the trust brought suit to except the debt from discharge under 11 U.S.C. Sec. 523(a)(4).   Section 523(a)(4) denies discharge for debts arising from fraud or defalcation in a fiduciary capacity, larceny and embezzlement.  The Bankruptcy Court granted summary judgment that the debt was nondischargeable based on defalcation in a fiduciary capacity.   The District Court affirmed.   The Court of Appeals affirmed as well, finding that "the conduct can be characterized as objectively reckless."    670 F.3d at 1166.

The beleaguered Randy asked the Supreme Court to consider whether "defalcation" applied "in the absence of any specific finding of ill intent or evidence of an ultimate loss of trust principal."    The Supreme Court agreed to hear the intent issue, but did not consider whether there could be defalcation in the absence of a loss of principal.   

What the Court Ruled

The Supreme Court reversed and remanded the decision of the Eleventh Circuit.   The Court held, as stated above, that defalcation required either a knowing breach of fiduciary duty or "gross recklessness" with regard to the conduct.    The Court did not get there by reading the dictionary.   After consulting an 1867 Law Dictionary, as well as more contemporary sources, the Court concluded that there was not a clear answer.   To illustrate the muddled state of the definition, the Court contrasted opinions from Augustus Hand and Learned Hand reaching differing conclusions as to whether mere negligence could constitute defalcation.   In one of my favorite passages from the opinion, the court noted that

A more modern treatise on trusts ends its discussion of the subject with a question mark.

Slip Op. at 5.   Great Scott!   If treatises are using question marks and Learned Hand disagrees with Augustus Hand, this must be a very muddled doctrine indeed!

 Instead of looking to definitions, the Court dusted off its maxims of statutory interpretation.   Using noscitur a sociis (which means "it is known from its associates"), the Court looked at the string of nondischargeable actions contained within section 523(a)(4):   fraud in a fiduciary capacity, defalcation in a fiduciary capacity and embezzlement.     Back in 1878, the Court had concluded that fraud, being associated with embezzlement, must mean "positive fraud . . . involving moral turpitude or intentional wrong, as does embezzlement."     This led Justice Breyer to declaim that "the statutory term 'defalcation' should be treated similarly."   Slip Op. at 6.    

Taking this analysis further, the court engaged in a stair-stepped equivalency analysis.   If the conduct "does not involve bad faith, moral turpitude, or other immoral conduct, the term requires an intentional wrong."   Id.  If conduct is not actually intentional, it must be its equivalent.  

We include as intentional not only conduct that the fiduciary knows is improper but also reckless conduct of the kind that the criminal law often treats as the equivalent. Thus, we include reckless  conduct of the kind set forth in the Model Penal Code. Where actual knowledge of wrongdoing is lacking, we consider conduct as equivalent if the fiduciary “consciously disregards” (or is willfully blind to) “a substantial and unjustifiable risk” that his conduct will turn out to violate a fiduciary duty.

Id.   In this context, I think that the willfully blind test would be met by a trustee who responded to an email from a Nigerian prince or who "invested" the trust funds by depositing them in his own bank account.   

Nevertheless, although defalcation thus understood was morally similar to fraud, embezzlement and larceny, it was not identical.   Embezzlement requires conversion while larceny involves taking and carrying away someone else's property.   Fraud requires a false statement or omission.    Thus, defalcation

can encompass a breach of fiduciary obligation that involves neither conversion, nor taking and carrying away another's property nor falsity.

Slip Op. at 8.  Finally, in a rather tepid endorsement of its own position, the Court noted that it had to find that the term meant something and that none of the parties had come up with a better idea.   To show that I am not making this up, I will quote Justice Breyer, who stated:

(I)t is important to have a uniform interpretation of federal law, the choices are limited, and neither the parties nor the Government has presented us with strong considerations favoring a different interpretation. In addition to those we have already discussed, the Government has pointed to the fact that in 1970 Congress rewrote the statute, eliminating the word “misappropriation” and placing the term “defalcation” (previously in a different exemption provision) alongside its present three neighbors. See Brief for United States as Amicus Curiae 16–17. The Government believes that these changes support reading “defalcation” without a scienter requirement.  But one might argue, with equal plausibility, that the changes reflect a decision to make certain that courts would read in similar ways “defalcation,” “fraud,” “embezzlement,” and “larceny.”

Id.

Having decided what the term meant, the Court vacated the Eleventh Circuit decision and sent it back to them to "permit the court to determine whether further proceedings are needed and, if so, to apply the heightened standard that we have set forth."   Id.

Thus, the Court completed its term paper on the meaning of defalcation.   But what does it mean to the bankruptcy community and to the parties in this case? 

Why The Ruling Is Good

As a matter of statutory interpretation, the Court should be commended for not simply picking a dictionary that it liked and pronouncing that the answer was clear.   Having consulted at least nine references (and two of the Brothers Hand, both the Learned one and the one who was merely Augustus) the Court realized that the various formulations were hopelessly inconsistent and they said so.   In my attempts to rely on the dictionary as legal authority, I have frequently had to concede that my preferred meaning was one of several contained within the same dictionary.    The process of judging requires more than simply opening a dictionary and pointing to a definition; it requires a thought process.   That is precisely what the court did in this case.

Next, the court required a finding of scienter.   There are five types of conduct that must be proven to be nondischargeable:   fraud under subsections (a)(2) or (a)(4), defalcation in a fiduciary capacity, embezzlement and larceny under subsection (a)(4) and willful and malicious injury under subsection  (a)(6).    Prior to this opinion, the Supreme Court had excluded "implied fraud or fraud in law" from the definition of nondischargeable fraud, Neal v. Clark, 95 U.S. 704 (1878), and had rejected negligence as the basis for willful and malicious injury, Kawaahau v. Geiger, 523 U.S. 57 (1998).   With the current ruling, the Court has raised the bar for all of the (a)(2),(4) and (6) exceptions to something much more than negligence.

To illustrate the danger of negligence based defalcation, consider the classic film, It's A Wonderful Life. When George Bailey sends Uncle Billy to the bank to make the deposit (that subsequently turns up missing causing George to contemplate suicide), there are many reasons he could be criticized as negligent:  Uncle Billy was a forgetful old man, who may have had a drinking problem and the funds were not kept in a locked and secure deposit bag.   But was it grossly reckless, that is, to say, the equivalent of an intentional breach of fiduciary duty? I don't think so.   Had this decision come out in 1946, George might not have jumped off the bridge (and a classic American film might not have been made).  

The opinion is also good because it distinguishes between creditors who deserve to be protected by having to prove a lower standard and those who should be required to establish a higher level of proof.

It is also consistent with a set of statutory exceptions that Congress normally confines to circumstances where strong, special policy considerations, such as the presence of fault, argue for preserving the debt, thereby benefiting, for example, a typically more honest creditor. See, e.g., 11 U.S.C. §§523(a)(2)(A), (a)(2)(B), (a)(6), (a)(9) (fault). See also, e.g., §§523(a)(1), (a)(7), (a)(14), (a)(14A) (taxes);§523(a)(8) (educational loans); §523(a)(15) (spousal and child support). In the absence of fault, it is difficult to find strong policy reasons favoring a broader exception here, at least in respect to those whom a scienter requirement will most likely help, namely nonprofessional trustees, perhaps administering small family trusts potentially immersed in intrafamily arguments that are difficult to evaluate in terms of comparative fault.

Slip Op. at 8.   The Court demonstrates wisdom in recognizing that family disputes can frequently turn into take no prisoners brawls where parties make ever more outrageous accusations against each other and hire ever more expensive lawyers to resolve conflicts that are more psychological than financial.   Even in a straight business dispute, it is not unusual for a party to spend many times more than the amount in dispute in attorney's fees to avenge a real or imagined wrong.   

It is not hard to imagine a wrongdoer who seeks to cover up his own large malfeasance by complaining loudly about his fellow partner's negligible misfeasance.   This is all a long-winded way of saying that requiring proof of bad intent may be a potent antidote to allowing trial by emotion and innuendo.  While it may be a lot to ask, it is at least possible that if the courts do not allow claims based on technical and insubstantial faults to prevail that at least some wrongdoers in plaintiffs' clothing may lose interest and turn elsewhere for their amusement.

Why the Ruling Is Frustrating

The Court's ruling is frustrating because it does so little to answer the dischargeability question in specific cases or even in this specific case.  In this case, the Bankruptcy Court granted summary judgment and was affirmed by the District Court and the Court of Appeals.  The Supreme Court reversed so that means that the Debtor wins, right?  Not necessarily.   Does it mean that the Debtor gets a trial?  Not even that much is certain.   Instead, the Supreme Court reversed the lower court's summary judgment with instructions to 

determine whether further proceedings are needed and, if so, to apply the heightened standard that we have set forth.

Slip Op. at 9.  What does it mean that the Court of Appeals should "determine whether further proceedings are needed"?    I read this cryptic reference to tell the Eleventh Circuit that it could remand the case to the Bankruptcy Court for a trial or it could solemnly consider the Supreme Court's "heightened standard" and reach the same result.   Given that the Plaintiffs below never alleged bad intent, it seems a given that the case should be remanded for trial or even rendered in favor of the Debtor.   However, the Supreme Court has ordered what may be a reversal in name only.  

Further, what is even more frustrating is that the Court offers very little guidance to the Eleventh Circuit in how to apply what it described as a "heightened" standard.   In its opinion, the Eleventh Circuit identified three levels of defalcation:   the Fourth, Eighth and Ninth Circuits allowed defalcation based upon mere negligence; the Fifth, Sixth and Seventh Circuits required a showing of recklessness; and the First and Second Circuits demanded extreme recklessness.   The Eleventh Circuit adopted the middle standard, that of recklessness.    The Supreme Court, on the other hand, adopted "gross recklessness" as the standard.  In its opinion, the Supreme Court hinted that it was siding with the First and Second Circuits. The high court noted that "at least some Circuits have interpreted the statute similarly for many years without administrative, or other practical difficulties" and then cited to decisions from the First and Second Circuits.   Thus, "gross recklessness" and "extreme recklessness" appear to be synonymous terms.

Rating Recklessness

So, how should courts distinguish between what is merely objectively reckless and that which is grossly or extremely recklessness?   One possibility would be to have the guy from Fast Times At Ridgemont High listen to the evidence.  If, at the conclusion of the case, he says, "dude, that's extreme," then the debtor loses.   That's probably not what Justice Breyer had in mind.   While the distinction between objective, extreme and gross negligence may seem like angels dancing on the head of a pin, a comparison  between the reasoning of the Eleventh Circuit and the Supreme Court's Kawaauhua opinion may be helpful.

In the Eleventh Circuit's opinion, the fact that the Debtor knew that he was engaged in self-dealing was enough to constitute "objective recklessness."   The Court wrote:

Applying the recklessness standard for defalcation to the facts of the instant case, this Court concludes that the bankruptcy court was correct in determining that Bullock committed a defalcation by making the three loans while he was the trustee of his father's trust. Because Bullock was the trustee  of the trust, he certainly should have known that he was engaging in self-dealing, given that he knowingly benefitted from the loans. Thus, his conduct can be characterized as objectively reckless, and as such, it rises to the level of a defalcation under § 523(a)(4). Accordingly, the bankruptcy court's order must be affirmed on the issue of whether the Illinois judgment debt was non-dischargeable under § 523(a)(4) as a debt arising from a defalcation while Bullock was acting in a fiduciary capacity.

 670 F.3d at 1166.   Thus, if the Debtor intended the act which violated the fiduciary duty, then he was objectively reckless.   However, in Kawaauhua, the Supreme Court rejected the argument that the Debtor need only have intended the act that caused the injury and instead held that the Debtor must have intended the injury.   While the standards of defalcation in a fiduciary duty and willful and malicious injury are different, the common denominator is an intent to cause the harm rather than the act that results in the harm. This equates to the language in Justice Breyer's opinion that the Debtor must have intended to breach a fiduciary duty or would have known he was breaching his fiduciary duty but for his willful blindness. 

To illustrate:

Under the Eleventh Circuit's approach, if the Debtor intended to drive his car at 70 mph in a 55 mph zone, he would be objectively reckless even if he had not seen a speed limit sign.

On the other hand, under Justice Breyer's approach, the Debtor would be grossly reckless if he saw the 55 mph sign but did not know how fast he was going because he had spray painted over the speedometer.   

The Take Away

At a minimum, we know that defalcation precedents from the Fourth, Fifth, Sixth, Seventh, Eighth, Ninth and Eleventh Circuits should be re-examined in light of the Bullock case.   The Debtor's best case will be to show that he did not know that he was breaching a fiduciary duty, while the creditor's case will be that the Debtor either actually knew he was violating a fiduciary duty or would have known had he kept his eyes open.